Business People Working Together - Making Money - Investing

The Three Types of Income

When most people think of wealth, they think of people who have a lot of earned income. This is why politicians and ignorant voters obsess over marginal tax rates on the wealthy. Little do they realize that the truly wealthy get most of their wealth from other types of income (see What is Wealth? A Modern Perspective).

There are essentially three types of income in the US tax code, in general order of tax burden from greatest to least:

  1. Earned income
  2. Portfolio income
  3. Passive income
Construction Working Working - Labor - Earned Income

Earned Income

Description

Also known as ordinary or active income, earned income is the money you make from actively-participating in an income-generating activity. For most, this means W-2 or 1099-MISC income received from their day job. It seems immoral because this is how the poor and middle class earn nearly all of their income, but earned income is generally taxed most highly of the three types of income.

Earned income is taxed using marginal rates at the federal level as well as at the state level in many states. This basically means that the more you earn, the more you pay in taxes as a percentage of your income. Did you get a big raise or bonus this year? Surprise! Your tax bill just went up.

For employees, there is another ugly side to earned income that is often overlooked. Income is taxed on a pay-as-you-go basis. What this means for employees is that a huge chunk of your pay is deducted from your paycheck and handed over to the government on payday. For investors, business owners, and the self-employed, there is more flexibility to make use of this money before you hand it over.

Advantages

Despite the heavy tax burden, there are some advantages to earned income:

  1. Lenders are more comfortable lending to people with a steady paycheck. This may not be the case if you are Warren Buffett, but is the case for most.
  2. If you have some skills, getting a job and earning a paycheck is less effort, risk, and capital-intensive than building or acquiring assets that yield portfolio or passive income
  3. Social Security payouts are based on how much you earn, although:
    1. This is hardly any reason to not earn portfolio or passive income
    2. I would not count on Social Security benefits if I were you; especially if you are young
Stock Market Investing - Portfolio Income

Portfolio Income

Description

Portfolio income is derived from capital gains, dividends, and interest yielded from your portfolio – i.e.:

  1. Stocks
  2. Bonds
  3. Exchange-traded products like exchange-traded funds (ETFs)
  4. Mutual funds
  5. Certificate of deposit (CD) accounts
  6. Savings accounts
  7. Checking accounts
  8. Other related assets

Advantages

Among other things, portfolio income is advantageous over earned income due to the following:

  1. This income is not subject to Social Security and Medicare taxes; which are quite substantial
  2. Investors may offset their capital gains with capital losses (subject to limitations)
  3. This type of income can largely be earned with minimal involvement on your part
  4. Portfolio assets can be held and invested in tax-advantaged accounts to further reduce taxes (e.g. 401(k), IRA, HSA, etc.)
  5. Qualified dividends and long-term capital gains are taxed at lower rates
    1. These are taxed at 0%, 15%, or 20% depending on your income and filing status
    2. Short-term capital gains and ordinary dividends are taxed at the same rate as your earned income. This may be high, but is at least without Social Security and Medicare taxes.
Money - Investing - Passive Income - Real Estate

Passive Income

Description

Passive income is derived from rental real estate, royalties, and other non-portfolio sources (above) in which you don’t materially participate to earn the income. An example of this is a limited partnership in which you’re a limited partner.

This type of income is generally treated most favorably under the tax code, which is why the wealthy focus so heavily in this area. You may hear rich people say such things as, “I made X dollars and paid zero taxes” and “My secretary pays more in taxes than I do.” They’re referring to the favorable tax treatment they receive from passive and portfolio income. Meanwhile, the poor secretary drowns in federal, state, and local income taxes as well as Social Security, Medicare, and employer taxes. Note that employer taxes are largely passed down to employees through lower compensation.

Advantages

Passive income is highly advantageous because:

  1. While you’re earning with minimal involvement, you’re free to earn in other ways or spend more time enjoying the finer things in life. Having passive income can be a huge benefit because it allows you to take greater risks. Let’s say you want to start a business but in order to do that, you need to quit your job. It’s easy to see that you will be more likely to succeed if you have passive income. Otherwise, you need to rely on your savings or external sources of funding to get by.
  2. Taxes on passive income are generally net of expenses (try offsetting your W-2 income with job-related expenses). This gives owners of these assets significant control over how much and when they earn income. For example, if my income was low this year, but I expect it to be much higher next year, I may decide to wait until next year to put new appliances in an investment property. This may reduce my overall tax burden.
  3. If your passive asset generates a net income
    1. Loss, even if that loss is only on paper, you can use this to offset certain other income (subject to limitations)
    2. Gain, that income is taxed as earned income. While the taxes on earned income are high, realize that this is on income net of expenses, not gross income.
  4. Taxes can be further minimized by investing in passive assets in self-directed, tax-advantaged accounts. For example, you can own a rental property in a 401(k), IRA, HSA, etc.
  5. Landlords can:
    1. Take advantage of powerful depreciation and capital gains deferment opportunities
    2. Largely pass increased costs of property ownership (e.g. higher property taxes) down to their tenants
Business - Office - Working Together - Business Income

What About Business Income?

Business income is not a type of income, but rather a description of where it’s earned. The type of entity that defines the business and how you receive income from the business determines how it’s taxed. Examples:

  1. If you receive rents from real estate held by a disregarded LLC, the income is passive
  2. If you receive a salary from your C corporation, the income is earned
However, there are some key advantages of business income to keep in mind:
  1. Taxes on business income are based on net income, not gross income. Many of the items employees pay for with after-tax dollars are paid by businesses with pre-tax dollars. This may apply to phone bills, travel costs, computer equipment, etc. The difference is substantial.
  2. If your business is able to operate effectively without your consistent involvement, this is an ideal situation for building wealth because there is only one of you and only 24 hours in a day
  3. Passive investments typically require significant capital and potentially greater risk. On the other hand, it’s possible to build successful businesses with minimal capital and less risk because you have more control.
  4. Depending on the structure of the business, you may be able to pass preferential tax treatment on income through to your tax return. Meanwhile you may maintain a certain degree of asset and liability protection (depending on entity type, jurisdiction, etc.)
  5. Businesses generally have a greater ability to deflect taxes by passing them onto employees and customers than do investors and employees

These and other advantages are the reasons why the wealthy receive much of their income from businesses they own or control.

Taxes - Income Tax Calculation - 1040

What About Pass-Through Income?

Pass-through income is not a type of income either, but more of a specification as to who pays taxes on it. This type of income flows through an entity and is reported on the owner’s tax return. C Corporations, on the other hand, report and pay taxes directly at the corporate level. A pass-through (AKA flow-through) entity may be an LLC, S corporation, income trust, or partnership.

Although there are strategies for using pass-through entities to reduce taxes, these are often used for other purposes. These entities may be used for asset protection, liability protection, and simplification. In fact, in many cases, the pass-through nature of many entities provides no tax benefits to the owners.

Freedom - Man Relaxing in Hammock by Waterfall - Passive and Portfolio Income

Why it Matters

Understanding the three types of income is crucial because taxes are typically the biggest financial drag on wealth building.

Most focus on building wealth by increasing their earned income. This is certainly better than focusing on watching TV or collecting purses, but is definitely an uphill battle under the US tax code. The harder you work and the more you earn, the more you pay in taxes. If you are at all trying, it doesn’t take long to be paying more in taxes than most people make.

This is not quite the case for those who earn portfolio and passive income. Generally speaking, increasing your wealth through portfolio and passive income opens new opportunities to pay less in taxes (at least on a percentage basis). This may also increase how much time you have to spend on other things.

What to Do About It

Accept the reality that, if you want to be wealthy, you’re probably not going to achieve that through hard work and earned income. It is true that there are some wealthy people whose wealth is primarily from earned income (e.g. CEOs, athletes, etc.). However, these examples are few and far between. You’re probably more likely to achieve similar or greater wealth with less effort, but greater focus on portfolio and passive income.

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